The YouTube of China Goes Legit

Until last year, General Motors' (GM) China marketers advertised the Chevy Cruze sedan with spy thriller-themed spots featuring Wentworth Miller, star of the TV show Prison Break. After Fox (NWS) canceled the series, Shanghai GM decided it wanted a new ad approach, one with "real life, real people," says Joan Ren, general director for Chevrolet marketing.

So the company teamed up with Youku.com (YOKU), China's most popular online video operator, to create a new campaign for the Web featuring young urban Chinese. So far Youku has shown 10 of the videos, most from 10 to 20 minutes long and made by a professional director, and they've gotten a combined 84 million views. Ren says she's pleased with Youku's production values and the authentic tone of the campaign. "They don't allow low quality," Ren says.

That anyone now associates Youku with authenticity is a step in the right direction for Victor Koo, the site's founder and chief executive. Youku launched in 2006 as a local version of YouTube (GOOG), which China's censors have long banned, and quickly became a premier place to download pirated movies and TV shows. (One of the most popular: Prison Break.) Now Koo is focused on working with GM, Procter & Gamble (PG), and other advertisers to create professionally produced Webisodes such as Crest Pro-Health II (a P&G serial set in a dentist's office that has attracted 33.5 million viewers) that target 20- to 30-year-olds turned off by programming offered by state-owned TV's hokey variety shows and melodramas. Youku has also cut deals with U.S. networks and studios to show Inception, Grey's Anatomy, and other content.

Koo figures legitimate programming, along with repairing Youku's reputation as a piracy haven, will attract advertisers and differentiate the company from China's many other YouTube knockoffs. (Youku is No. 1, with 35 percent of the market in China for online video.)

His next challenges: making a profit and appeasing Beijing censors. After raising $203 million from its December initial public offering on the New York Stock Exchange (NYX), Youku has lost $87 million since 2008 on sales of $86 million, and it's likely to lose $21 million on sales of $110 million this year, according to a Mar. 1 report by Goldman Sachs (GS) analysts. Not to worry, says Koo: "We are on the path to profitability." Investors seem to buy that message. Youku's stock price has nearly quadrupled since the IPO. The real question, says Eric Wen, an analyst in Hong Kong with Mirae Asset Securities, is not whether Youku can move out of the red, but how big it can get. Less than 4 percent of Chinese advertising goes to online video, Wen says, vs. a third for TV, so there's plenty of room to grow. "Breakeven is not a concern," he says. "There's a tremendous amount of profit down the road."

As for Beijing, Youku needs to show China's censors that it is free of material the Communist Party finds subversive. The company and rival sites "are trying to outdo each other in the efficiency of their self-censoring mechanisms," says Duncan Clark, chairman of Beijing-based consultancy BDA China. With dissidents inspired by upheaval in the Arab world trying to use social networking sites to organize protests in China, authorities are particularly nervous, he says, but the smooth-talking Koo gives Youku an edge. The CEO is "as comfortable talking with bureaucrats as with venture capitalists," says Clark. "He is able to play both sides very well."

The Chinese government is also starting to crack down on illegal downloading, says Jeanette K. Chan, a partner in Hong Kong with the law firm Paul, Weiss, Rifkind, Wharton & Garrison. Operators, she says, won't be able to survive "unless they have good content—not pirated content."

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That means the competition for legit content is heating up. Tudou, China's No. 2 site, announced on Mar. 3 a deal with Walt Disney (DIS) to show Desperate Housewives, Lost, Criminal Minds, and Cougar Town online, while smaller rival Ku6 Media last year formed a partnership with Warner Bros. (TWX) and Sony (SNE) to stream movies and TV shows. Koo says he'll be making more deals with studios while also creating more exclusive content like the Web series for GM. "We are going to keep investing in Youku originals," he says. The days of unauthorized downloads are numbered, he adds. "You can't build a business out of that," Koo explains. "If you can't monetize it, what's the point?"

The bottom line: Youku faces tough competition and scrutiny from Beijing. Its original-content strategy is winning over investors.